Start-up Financing & Start-up Fund(a)s

In-House Counsel

Start-up Financing & Start-up Fund(a)s

Ashish Chandra | May 2015

The past year the whole World witnessed start-up buzz and as many as 3100 start-ups mushroomed in our home –land India, a majority of which is comprised of technology and software product landscape start-ups. As per the most premiereconomy progress report carried by the Government of India (the Economic Survey 2015 reports)1 –this whopping number was responsible for making India the 4th largest start-up hub in the World.In the same report, NASSCOM anticipated that this sector will scale up at 12-14 per cent to reach US$ 133-136 billion in 2015 -16.Snapdeal is all poised to become a part of this buzz this financial year around.

The implications of the start-up buzz in the World around can also be seen in the curriculum and business case studies of all premium business schools of the World. Forbes recentlycarried an interesting report that prospective MBAstudents laid emphasis on choosing curriculums over colleges which is a rising trend amongaspiring business students; to choose entrepreneurship curriculum over college brands. This trend was further endorsed by an annual increase of 20% to 30% at the Harvard Business Schoolfor entrepreneurship related curriculum offerings.

While ideas are beingincubated, no idea or business can float without the fuels (here funds). Neither the Government nor the banks lend help to these ideas thus making it a challenge to sell their ideas and enter the investors’ arena and fight out one’s ideas as better and brighter over the others. Unfortunately sometimes the eggs crack before they hatch.Holding true the adage that there is no sure short formula that one can refer before venturing into business winning game plan.Financing for start-upsis thus a big challenge the creators of smart ideas need(seeding) funds to operate their business.

The various financing stages which a start-up company necessarily goes through are chequered as:

STAGE 1: MOONLIGHTING & INTRAPRENEURSHIP- GOT A GREAT IDEA AND WILLING TO BET YOUR WHOLE LIFE ON THE SAME BUT CANNOT LEAVE YOUR JOB UNTIL YOU HAVE THE BASIC CONCEPT AND PRODUCT READY.

This is the most crucial phase and first stage of an entrepreneurship where you want to risk your good paying and stable job for unknown challenges and risks. But, as they say, it’s a high risk high rewards game. Usually this stage lasts for 6 months where you invest part of your salary in developing concepts and the alpha version of your product. This stage where you work outside of your normal working hours towards your goalis called “moonlighting”. Make sure moonlighting is outside of the restrictions in your employment agreement with your existing employer (consult an IP and employment lawyer). Take a stock of all your savings and keep all paperwork, certificates and other documents ready for liquidating in a tax efficient manner (consult your tax counsel). Ensure a smooth and healthy exit from your job. Don’t forget to mention to your employer that you are going to start on your own and share your idea as if you will be sharing with a financier. You may never know your employer may turn out to be your first financier. It’s a win-win! You continue in your job and develop your business with ownership rewards. Its known as ‘intrapreneurship’. In such case, it is advisable to create a special purpose vehicle where both you and your employer hold a negotiated equity stake and you are designated as CEO:

STAGE 2: BOOTSTRAPPING – SELF FUNDING YOUR VENTURE

This is self-funding your venture with your savings. You may need to borrow from friends and family. At this stage you will decide the nature of the legal entity i.e. whether a company or LLP and its jurisdiction of incorporation. You would want to issue either equity or convertible debt notes to your friends and family with a Zero or minimal interest rate. The funding instrument will depend upon the residential status of your initial financier. Companies Act, LLP law, FEMA and Income Tax would essentially come into play for structuring and issuing these instruments.

STAGE 3: EARLY STAGE FINANCING – FUNDING FOR EARLY STAGE OF GROWTH

Your concept or prototype is ready with bootstrapping. You have almost exhausted your savings and initial funding from your friends and family. What next? Here are various options of Early Stage Financing:

Angel Investment – This investment can come either from high net worth individuals or through their group or association. You may need to do a little bit of marketing and social media engineering to get to Angel investors. It’s like giving various job interviews. At this stage your commercial acumen need to play a key part as Angel investors will talk about taking ownership stake in your company. You will either issue equity instrument or convertible instrument or a combination of both to the Angel investors. You may also concede a board seat in favour of the Angel. Be careful about your drag obligations and your right to raise further capital without getting blocked by angel investors. At this stage, it would be a good idea to create a separate stock option or earn out pool for the founders, but in compliance with the newly inserted restrictions under Companies Act. Carefully analyse Term Sheets and don’t forget to consult a corporate lawyer and a tax counsel.
Crowd-funding – this can be of two types:

Equity based: You post your business plan and the basic version for product on a crowd-funding platform and seek investment from various people and you give equity in lieu of that. In India, SEBI has issued a consultation paper on ‘Crowd-funding in India’ in the month of July 2014.
Donation based: You post your business plan (usually on a creative side like book, play, movie etc.) on a crowdfunding platform and seek donation. You give your final product to the donor after the product is ready. Two of the famous crowd-funding platforms are kickstarter and indiegogo

Incubators / Start-up accelerators: Business incubators / accelerators help new start-up companies to develop their ideas and products by providing business and technology enabler services, administration and office space and supplies. These entities have pool of talents and mentors who help start-up founders to be ready for next round of big investments from sophisticated investors. Incubators and accelerators usually take significant ownership stake from start-up companies in lieu of their services. Lots of engineering and management schools have their own incubators where their students develop on ideas. The legal planning will be similar to what you will do when you get angel investment. At this stage you may need assistance from an IP lawyer to understand who will own the IP created in such incubators viz., founders, company or the incubator?
Other modes of early stage financing:

Vendor financing: This could be either a long payment cycle within the legally permissible time limits or could be issuance of shares to the Vendor in lieu of services. In fact, many law firms in Silicon Valley take up shares in start-up companies as consideration of legal services to them.
Customer financing: Seeking advance money from the potential customers of the product / services which the start-up company will be developing.

STAGE 4: HIRING OF HIGHLY TALENTED PEOPLE AT A REASONABLE CASH COMPONENT

Success of innovation based start-ups depends upon the quality of people. Hiring of good talent is expensive. Startupcompany can create ESOP pool to grant stock options to attract good talent. The vesting period, liquidity option, accelerated vesting etc. terms can be incorporated to make sure talented employees make real wealth with stock options. Indian start-ups companies have to comply with Companies Act, 2013 and relevant rules and also Income Tax Act for the grant, vesting and taxation of stock options. Indian subsidiary of foreign companies, where stock options of foreign company is issued to the employees of Indian subsidiary, has to comply with relevant FEMA rules and Income Tax Act.

STAGE 5: GROWTH-PHASE (SERIES TYPE) FINANCING – VENTURE CAPITAL AND PRIVATE EQUITY

This is a stage where your idea has becomes reality and you have launched your product. At this stage you require bigger investments to help you grow and scale up. Series type investments come from sophisticated private equity and/or venture capital firms. These are usually a mixture of equity and convertible instruments. Mostly these are preferred stocks. In India, SEBI has various regulations on the private equity and venture capital investments into start-up companies.

STEP 6: RAISING FUNDS THROUGH STOCK MARKET – GOING IPO – A DREAM COME TRUE AND REALIZATION OF GAINS

For IPO you will decide whether you are going public to invite fresh capital or to grant exit or liquidity to the existing investors or a combination of both. You will also decide whether you want to list in India on primary stock exchanges i.e. BSE and NSE or on the SME exchange, or you want to issue ADRs / GDRs to tap the foreign markets.

There are certain challenges for these start-ups to list on primary exchanges due to past track record and lock-in issues. To come to their rescue, SEBI recently proposed a stock market for start-upsto provide better access to funding for start-ups. However, much has been anticipated even before the regulation is implemented. The risk of failure for a start-up is evidently higher as compared to fully grown company.

Per the SEBI, starts-ups2 will now be able to list on Institutional Trading Platform (ITP) without having to do an Initial Public Offering (IPO), making it easier to list. The ITP will not be accessible for the general public. The ITP will be accessible only for institutional investors or sophisticated investors, i.e. Qualified Institutional Buyers (QIB) and Non- institutional Investors (NII). The proposal may be able to mitigate risks of investing in start-ups and foster confidence to investors. In addition, to fostering confidence the listing would give the start-up visibility and opportunity to reach wider investors/ audience.

About Author

Ashish Chandra

Ashish is currently working as General Counsel for Snapdeal.com. Prior to Snapdeal, Ashish was the Vice President & Head of Legal (Media & Technology) with Reliance Jio Infocomm and provided legal leadership for the roll-out of 4G network and setting up of online media, payment and cloud computing businesses. Prior to Reliance, he worked with Star TV and eBay India. Ashish is Law Graduate from Delhi, is a Company Secretary and diploma holder in IT and IPR laws from Indian Law Institute, Delhi and National Law School, Bangalore.